Changes in the global economy, specifically within the macro-economic environment pose a substantial challenge for businesses in the coming years. Low interest rates and falling asset prices could spell disaster for the investment and insurance industries. Unless, that is, measures to safeguard against potential disaster are implemented on a wide scale.
Can the insurance industry learn vicariously?
In 2013, the European Insurance and Occupations Pensions Authority (EIOPA) published a paper titled: Supervisory Response to a Prolonged Low Interest Rate Environment. The paper used Japan as an example of what can happen if no one takes action to address prolonged low interest rates and their effect long-term on insurance. During the 80s, Japanese insurance providers started building books of guaranteed business, which made them vulnerable to a prolonged period of low interest rates. As a direct result, in the late 90s and early 2000s, seven Japanese firms had to close their doors. The government had to step in and enact legislation allowing insurers to alter guaranteed rates if they’re especially vulnerable to bankruptcy.
According to EIOPA, the EU and UK are vulnerable to exactly the same situation.
How do we fare on stress tests?
Back in 2011, after a ‘low yield scenario’ stress test, EIOPA found that 5% to 10% of companies tested were at risk of severe problems. The capital position of a far higher number of companies was at risk of deterioration, and several knock-on problems.
The results of the EIOPA’s most recent stress tests (a ‘low-for-long-yield’ and a ‘double-hit’ scenario) looked prolonged low interest rates and low rates combined with a fall in asset prices. Companies are at risk financial hits of €100 billion and €160 billion in each test respectively. The only way to avoid the scenarios is to come up with a coordinated supervisory response. To this end, the EIOPA has submitted several recommendations to the National Supervisory Authorities (NSAs).
Insurers, however, aren’t impressed with the tests and have criticised them for testing unlikely scenarios and ‘freak’ situations. Furthermore, the tests were not truly representative of the industry, as they didn’t include non-life and unit-linked business that are far more resilient in the face of low interest rates. According to Olav Hones, deputy director general of Insurance Europe, if these businesses had been included, the overall level of resistance would have been higher.
Stress tests of the future
EIOPA indicated that the stress tests are intended to evaluate insurers’ vulnerabilities and not as a pass or fail examination of the industry. They assess the insurance sector’s resilience within an extremely adversarial market development phase based on a common analytical framework. An added value of the stress tests is the opportunity to examine increased systemic risks within conditions of stress.
Regardless of whether you believe in EIOPA’s methodology or you agree with insurers and think they look at freakish and unlikely scenarios, stress tests are getting a facelift.
The European Banking Authority (EBA) recently published guidelines on stress tests for deposit guarantee schemes (DGSs). The aim is to provide a systematic methodology for planning, running and reporting on stress tests conducted by DGSs to assess resilience to adverse conditions during periods of banking stress.
The guidelines aim to promote the consistency and quality of stress tests and to use data to create a framework for financial stability. Methodological principles include the required stages that need to be completed, the sorts of scenarios to be simulated and necessary areas and indicators for measuring. The tentative date for these stress tests to begin is 3 July 2017.
The first EBA peer review is projected for 2020 with the DSGs testing operational and funding capabilities that cover the most important areas and functions activated by DGS intervention. Results are expected to be reported by July 2019 and should give an indication of the value and information required for the first EU-wide overview of DGSs resilience.